Is Securitization Coming Back?

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In a nutshell, yes, but not in the way the industry hopes.

In a Financial Times article. Gillian Tett files a somewhat dumbfounded report from the European Securitization Forum in Cannes. While the event has gone wildly downscale from last year’s bash, the participants were hopeful that the return of good times was just around the corner. As we’ll see posthaste, Tett doesn’t buy it. She sees regulators primed to attack the loopholes and oversights that allowed the high profit products, particularly CDOs, to flourish. Yes, securitization will come back, but it seems certain to be only the plain vanilla, low margin sort.

There’s another constraint that Tett omits, Securitization depends on credit enhancement. That can be accomplished three ways: overcollateralization, credit default swaps, and insurance. The latter two were the most common methods for more complicated deals. Yet as the credit crisis has progressed, CDS protection writing capacity is scarce and costly, and measures to move CDS to exchanges and force standardization of terms would make them less suitable for new issues. Paul Jackson wrote about the problem shortly after the annual meeting of the American securitization industry’s big confab:

While the monoline business may or may not be less important in the municipal bond markets due to the unbelievably low incidence of defaults, the guaranty business is actually far more important to the MBS business than most have given attention to thus far — precisely because defaults can and do happen.

For secondary mortgage market participants, resolving this crisis isn’t just a piece of the puzzle; it might be the puzzle. At the American Securitization Conference in Las Vegas last week, many investment bankers suggested on panels and in hallways that the bond insurer mess is the single largest issue keeping the private-party market from having a chance at establishing any modicum of recovery going forward.

As we know, the monolines have gone down for the count.

From the Financial Times:

[W]hat was more noteworthy about this week’s {European Securitisation Forum] gathering in Cannes was just how many bankers still seem to think – or hope – that this champagne drought will prove short-lived.

For while nobody is brave enough right now to predict that subprime mortgages are about to return, there was plenty of excitement in Cannes about opportunities in other asset classes. Auto loans, for example, are currently considered hot; so is Islamic finance. Meanwhile, one banker chirpily predicted that we will soon see the launch of some CDOs based on Russian consumer debt. “This stuff always comes back. Just give it a few months,” he said.

Well, perhaps. But I suspect that some of this optimism is pretty delusional. For the events of the last year have not just hurt investor confidence in the securitisation process, they have also left regulators horrified by the degree to which bankers have abused banking loopholes in recent years.

In normal times, bankers tend to be pretty cynical – even scathing – about what these regulators might think. (Indeed, one top representative from PWC had the temerity to declare in Cannes this week that the industry already had the regulators “under control”, although he noted the European parliament was less malleable.)

I suspect, however, that bankers would be foolish to discount the regulators this time. For some of the ideas currently floating around the supervisory community could potentially have a big impact on the securitisation world for years to come.

Take the matter of the capital treatment of trading books. In recent weeks, some Western supervisors have conducted intensive analysis on banks’ trading books and discovered, to their horror, that some banks have been exploiting so many regulatory loopholes in recent years that they have got away with posting virtually no capital reserves against assets, such as the senior tranches of CDOs.

This situation reflects badly on the regulators who devised these rules – and even worse on supervisors who were supposed to police them. However, now they have woken up to the problem, many regulators want to act, probably by imposing much higher capital charges for assets in the trading book.

This has big implications for parts of the CDO world. Most notably, the banks will have far less economic incentive to create instruments such as mortgage-bond CDOs, or so-called single-tranche CDOs, if they can no longer park the senior CDO debt on their trading books for free.

In other words, one upshot of the regulatory rules is that when securitisation does return, it is likely to be in a dramatically simpler form, centred around more traditional lines of business, such as creating mortgage-backed bonds. And the key point about this is that these “simple” business lines tend to be far less profitable than the complex stuff or, more accurately, wacky stuff that uses free money in spades.

So the upshot is this: securitisation is certainly not dead; but it is unlikely to produce endless champagne again anytime soon. And anybody setting out for the ESF events in the coming years had better develop a taste for cheap beer.

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  1. Anonymous

    Yves, nice post but it is important to recognise the difference between traditional securitisation and CDO and derivative-based securitisation. If securitisation industry in its vanilla form (i.e. mortgages, car loans, credit cards and whole business) can be revived, that should be welcome – this is where the entire economic purpose of securitisation is.

    CDOs and the like were typical top of the cycle, bubble stuff: all fee extraction and no economic value: the point here is that CDOs exploded in the last couple of years whereas the securitisation industry has been around for a while longer.

    As for sources of enhancement, I fail to see why securitisation (again, as opposed to CDO’s etc.) cannot rely on endogenous enhancement i.e. over-collateralisation, bond subordination etc. That’s how typically things are done so I am not sure if the demise (?) of the CDS market is relevant here.

  2. Yves Smith

    We are in agreement on the basic premise. But what was striking reading Tett’s and Jackson’s earlier piece was the degree to which the securitization industry has become dependent on high profit products like CDOs. The subtext of both discussions was that those instruments had to come back for the producer side to survive. Clearly, the incumbents are only now coming to grips with how far the downsizing will have to go.

  3. Fledermaus

    This situation reflects badly on the regulators who devised these rules – and even worse on supervisors who were supposed to police them.

    Oh what a load of BS. The bankers paid off politicians to put a bunch of free wheeling anything goes cronies in charge of regulations and cut enforement and investigation budgets. And NOW they complain about them not doing their job?

    The bankers and finance people got the regulatory sceme they wanted, if they created problems it’s their own lookout now.

  4. Ginger Yellow

    Yves, to reinforce the first comment, the European securitisation industry is much less dependent on CDOs than the US market. Sure, a fair amount of the mezzanine bid for RMBS was CDOs, but by no means all and probably not even a majority. There was plenty of real money interest from hedge funds and there’s even more now that spreads are so high. The real problem has been the triple-A bid from SIVs, which has obviously evaporated. Part of the optimism comes from Basel II, which makes triple-A ABS very attractive for banks, even on balance sheet, once the mark to market concerns alleviate.

    I simply don’t agree that the market needs complex CDOs for the sell side to make money. Sure your typical German auto loan ABS doesn’t make anyone much cash, but nor does a Eurobond. There’s also plenty of fees to be earned in vanilla asset classes in emerging markets such as Russia or Poland.
    Nobody’s disputing that it’s going to be a smaller market with fewer people – most CDO teams have been disbanded or drastically slimmed down, as have CMBS and other teams. There’s definitely more pain to come, but there’s also reason to believe that the market will come back to, say, 2003/2004 levels within the next year. A lot depends on the macro picture, however, and that’s pretty ugly. But that’s no different from any other market.

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